Debt Financing and the rising Cost of Living

By Carl Dunton

Without stating the obvious (the rising cost of living), there are many factors putting financial pressure on companies and consumers, from increased costs of goods and materials to the spiraling cost of credit (for companies and consumers). Debt laden businesses will be especially impacted as debt (loans or bonds) comes with terms and conditions attached. Actual and, in some cases, anticipated breaches of these terms can lead to stops on future funding (at a time when the need for cash is at its greatest) or, worse, an immediate need to repay in full; putting pressure on cash reserves and, potentially, a business’ solvency.

In such uncertain times there is a need to understand any provisions relating directly or indirectly to the health of the debtor, its group, its business(es) and the potential consequences. Financial covenants and material adverse change provisions need particular consideration. Breaches can lead creditors to query the on-going feasibility of a business, its ability to meet interest payments and ultimately repayment of principal.

Financial covenants link directly to the performance of the debtor and its business

Financial covenants vary in type depending on the underlying business. Debt to EBITA and Interest Cover ratios are two examples where the impact of the rising cost of living, for some businesses, could have a detrimental impact:

  • Debt to EBITDA ratio - the debt held by the debtor cannot be greater than a multiple of the EBITDA of that business. Earnings will be adversely impacted in certain businesses which rely more on accessing a consumer’s discretionary spend e.g. recreation and leisure businesses, clothing/fashion, non-essential retail, travel related entities (e.g. hotels or airlines). The debt remains the same, so compliance becomes more challenging;
  • Interest cover ratio - this is the ability for a business’ income stream to cover its interest obligations. In a property related business this ratio would be based upon the passing rent received by the debtor from its tenants. Tenants (whether commercial or residential) impacted by the rising cost of living may default on or walk away from leases, not pay rents (or pay them late) and tenants may not be replaced, all leading to a reduced income and pressure is placed on the covenant.

Material Adverse Change clauses (MAC) Clauses

MAC clauses are common in debt documentation. Formulations are often negotiated. However a common formulation is the debt provider(s) concluding that:

“an event or circumstance has occurred which has or is reasonably likely to have a material adverse effect on the business, operations, property, condition (financial or otherwise) or prospects of the Debtor”.

This is a current and prospective test and can look at all aspects of a debtor’s finances including balance sheet items (assets and liabilities), profit and loss account items and cash-flow or liquidity items, and the impact on these of the state of the markets in which it operates. A creditor or group of creditors could, in a business which they believe will be adversely impacted by the rising cost of living (e.g. a manufacturing business where raw materials and the cost of fuel has increased but these costs cannot be passed on to consumers and little/no cost cutting measures can be implemented), state that a MAC has or is reasonably likely to occur.

What should debtors and creditors be doing?

Both debtors and creditors need to monitor for actual and anticipated breaches.

Debtors should up the monitoring of financial covenant compliance on a “real time” basis (not just annually/semi-annually), have a better understanding of any “cure” provisions and the process and consequences relating to any default or enforcement scenario.

Creditors, where they suspect financial difficulty, should use existing information covenants to receive information outside of the usual information cycles, be proactive, ask questions on the state of the business, understand any restrictions on debt transferability, be aware of their position in the creditor’s debt stack and understand the process and voting thresholds for waivers, amendments or enforcement actions.

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